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Instruments of Monetary Policy 
 
The main instrument used by a central bank to achieve its goals is 
the 
interest rate 
– also known as the discount rate or base rate. This is the rate at 
which the central bank is ready to lend to commercial banks. Let us look at how 
a rise in the discount rate affects the banking system and the financial markets. 
A rise in the discount rate makes it more costly for commercial banks to borrow 
from the central bank. As we have just discussed, banks may wish to borrow if 
they feel that their level of reserves is too low. If the cost of borrowing from the 
central bank goes up, commercial banks are less inclined to borrow from it. 
Since borrowing from the central bank is also a source of bank reserves, an 
increase in the interest rate and subsequent reduction in borrowing from the 
central bank puts the commercial banks in a situation where they have less 
reserves than they planned to hold. In response, they will reduce their lending 
by increasing the rates they charge to households and firms. In practice, 
commercial banks react very quickly to increases in the discount rate. Another 
instrument of monetary policy is 
open market operations
which involve the 
purchase or sale of government securities by the central bank. When the central 
bank buys treasury bills or government bonds from a commercial bank, it makes 
payment simply by increasing the amount of reserves in the account of the 
commercial bank. Thus, the central bank uses its monopoly power over money 
creation. As the level of reserves increases, the commercial banks realize that 
they have more reserves than they need for prudent 
operation. Therefore, they extend their lending to households and firms by 


lowering their interest rates. In contrast, when the central bank sells treasury 
bills or government bonds, the commercial bank will make the payment for 
the securities from the reserves it deposited at the commercial bank. After the 
transaction has been completed, the level of reserves will be lower than before, 
and hence the commercial banks will raise their interest rate to cut their 
credit to households and firms. In both cases, the change in the reserves 
translates 
into a change in the credit provided to firms and households. 
Finally, the central bank also requires the commercial banks to hold a 
percentage 
of their deposits as reserves. These are called 
required reserves
, and the 
percentage is known as the 
required reserve ratio
. These reserves are meant to 
ensure some minimum level of prudence, even if not all commercial banks want 
to operate as prudently as they should. If the central bank increases the reserve 
ratio, then the actual reserves of the banks will fall short of the required ratio. 
Thus the banks will have to raise their interest rate to cut back on loans, and 
deposit the money freed up as reserves at the central bank. The opposite 
happens if the central bank decreases the required reserve ratio. Suddenly banks 
have more reserves than they want to hold, so they will lend the money instead 
of holding it at the central bank. So if the required reserve ratio increases, the 
commercial banks lending to households and firms falls. The opposite happens 
when the required reserve ratio decreases. It is important to point out that 
required reserve ratios are very stable – central banks do 
not like to change them too often. Our discussion indicates that the level of cash 
deposits and commercial banks' reserves held at the central bank plays an 
important role in transmitting the central bank's monetary policy to the banking 
sector and the financial markets. The cash in circulation and the reserves of 
private banks together are called the 
monetary base. 
As we have already said, 
the central bank has a monopoly over money creation, more precisely, over 


monetary base creation. The power of a central bank rests on its ability to 
control the monetary base. You may wonder, however, why the monopoly to 
create the monetary base makes the Bank of England or other central banks so 
important for the economy? After all, financial markets had become very 
complex and large by the beginning of the twenty-first century. If most 
transactions are carried out with credit cards, cheques and bank transfers, why 
would the ability to create cash or reserves matter? 
First, we should recall that cash is still used in a large number of transactions. 
Although its scope and use have diminished over the last 30 years, it does not 
seem that cash is going to disappear in the near future. Second, evenif a 
transaction does not involve the use of cash or reserves directly, it typically 
requires that someone somewhere holds a monetary base. For example, paying 
by cheque assumes a bank account with deposits, and the bank is required to 
hold a fraction of these deposits as reserves. Similarly, credit card bills must 
also be settled using cash or bank deposits. In the latter case, the bank has to 
hold the corresponding required reserves. In some sense, we can say that the 
whole financial system rests on the monetary base – and this makes the central 
bank a powerful institution. The amount by which a change in the monetary 
base is multiplied to determine the resulting change in the money supply is 
called the 
money multiplier


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